Retirement Planning Within Your Rental Property

By Jason Watson, CPA
Posted Saturday, September 28, 2024

Rental property retirement planning might not be very exciting since most real estate investors and rental property owners view retirement through a lens of rental income and property appreciation rather than traditional investments in IRAs and 401k plans. However, from time to time, WCG CPAs & Advisors chats with a rental property owner who wants to contribute to a solo 401k plan.

The problem is simple- you generally need income that is subject to self-employment taxes (aka, Social Security and Medicare taxes). Rental income short of hotel-like operations is passive by nature and even with the short-term rental loophole or real estate professional status, it is not subject to self-employment taxes and doesn’t allow for a 401k contribution.

What can be done? You need to change the color of money. While most people want to go from earned income to passive income, you need to hit the cross-town traffic and go the other way.

Ok, Jimi, now what? You would charge your rental properties a management fee that is usual and customary. 5-10% for long-term rentals, and perhaps 20-40% for short-term rentals. This is paid like any other management fee where money is paid from the rental checking account to your management company checking account. From there, you can contribute to a solo 401k plan.

However, this quickly creates three potential problems-

• Depending on your state and regulated industry rules, you might have to register your management company. This might be extreme, right? You could also consider the payments from the rental properties to your management company as consulting fees.

• You are now paying self-employment taxes of 15.3% unnecessarily. As such, if your 401k investments have a rate of return around 7.5%, it will take two years to recover from this additional tax. 401k contributions only reduce income taxes, and not self-employment taxes. Sure, the tax deferral might mitigate this unnecessary tax expense, but it remains a tax deferral and not a tax deduction or avoidance technique.

• You might easily run into a situation where your management fee or consulting fee creates a rental loss. However, that loss might be limited based on passive activity loss limits. The problem is that you are recognizing income from the management or consulting fee, and it might be phantom income. Sure, you can reduce this with a 401k plan contribution and Yes, your passive activity losses will eventually offset future rental profits or release upon sale, but be aware of the corner you might be painting yourself into.

For the 2024 tax year, you contribute $23,000 plus $7,500 for catch-up (those 50 years or older) to a solo 401k plan. If you have multiple rental properties, each activity would pay a separate fee to the management company, and then in turn, the management company would make a 401k contribution.

Keep in mind there are two pieces to the 401k contribution puzzle- your contribution plus the company’s discretionary contribution. A $30,000 management fee would convert into $25,440 in total 401k contributions ($23,000 for the 2024 tax year plus 20% of net earnings which has special calculations) leaving some taxable income. A $23,000 management fee would convert into $21,375 leaving no taxable income after considering the self-employment tax deduction.

Sidebar: If you think you are clever and use a management fee as a way to get around passive activity loss limits, you’ll run into trouble. What are we talking about? You pay out a management fee, and deduct your travel, home office and all kinds of expenses on Schedule C, Profit and Loss From Business, of your individual tax return. Creating recurring losses on Schedule C could trigger an IRS examination under hobby loss rules.

Armed with all that, the rest of this chapter is aimed at retirement planning for the small business owner, or the collector of management or consulting fees. This is a truncated chapter. For a complete review of small business retirement including controlled groups, multi-member LLC 401k plans, and other issues, please see our other book, Taxpayer’s Comprehensive Guide to LLCs and S Corps.